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MSc Degree Examinations 2021-22

Economics

Corporate Finance

Question 1

You are considering establishing a biotech company, BIO Inc. According to your estimates of the expected net cash flows BIO will generate, this investment will have a positive NPV at discount rates less than 9.45% and a negative NPV at discount rates greater than 9.45%. The target debt-equity ratio for BIO is 0.2 and you expect to keep it constant over its life (which is assumed to be infinite). You identify a company with similar business. You identify a company with similar business. This company has outstanding riskless debt with market value £61.6 million which is expected to remain constant for ever. Its market capitalisation (market value of its equity) is £140 million and its equity beta is 1.635. The risk-free interest rate is 2%. The expected return on the market portfolio is 8%. The corporate tax rate is 30%. (Word Limit: 300 words for each of the four parts (a, b, c, d) below).

a) Suppose that if your company’s debt-equity ratio is 0.2 debt is riskless. Would you establish BIO given that you could keep the debt-equity ratio constant at 0.2? (10 marks)

b) Would you establish BIO if it were all-equity financed? Is your decision different from that in Part (a)? Explain briefly your answer. (8 marks)

c) Suppose now that instead of trying to keep to a constant amount of riskless debt the same comparison firm (with the same market values for debt and equity), has a target debt-equity ratio of 0.44. For this level of leverage, debt is essentially riskless. What is the equity beta of the comparison firm? Is it different from that you are given in the question above? Explain briefly your answer. What are the effects of this change? Would this change affect your decision about establishing BIO? Explain briefly your answer. (8 marks)

d) Suppose now that the comparison firm’s outstanding debt is risky. Would the equity beta of the comparison firm be higher or lower? Would that affect your decision about establishing BIO? (Hint: You do not need to do any calculations). (7 marks)

Question 2

a) Explain how the tax benefits and bankruptcy costs of debt determine the optimal capital structure of firms in the context of the static trade-off theory. What are the predictions of this theory? Are these predictions consistent with the empirical evidence? (17 marks) (Word Limit: 600 words)

b) How can mergers and acquisitions create value? Could a merger lead to an increase in the value of debt and a decrease of equity value? (16 marks) (Word Limit: 600 words)

Question 3

a) Why do dividend payments convey information about the quality of a firm? What are the predictions of signalling models of dividend policy? Are these predictions consistent with the empirical evidence? (16 marks) (Word Limit: 600 words)

b) Why do entrepreneurs choose an inefficiently low effort level when they issue equity to outside financiers? Could the issue of debt mitigate this problem? (17 marks) (Word Limit: 600 words)

Question 4

Consider an entrepreneur who, at date 1, can choose between two mutually exclusive projects: Risky, Safe. Both projects require an investment of 486 at date 0. At date 2, the risky project yields either 1323 with probability 0.4 or 108 with probability 0.6 whereas the safe project yields either 1080 with probability 0.5 or 216 with probability 0.5. All agents are risk neutral and there is no discounting. The entrepreneur’s choice cannot be observed by outside financiers. Capital markets are competitive.

a) Suppose that the entrepreneur has enough funds to undertake the project without borrowing. Which project will he choose? (5 marks) (Word Limit: 100 words)

b) Suppose now the entrepreneur has no funds available and raises the required amount by issuing equity. Which project will he choose? Explain briefly why. (5 marks) (Word Limit: 200 words)

c) Suppose the entrepreneur raises the required amount by issuing debt. What is the face value of debt issued in equilibrium? Which project will be chosen? Is your answer different from that in Part (b)? Explain briefly why. (8 marks) (Word Limit:

400 words)

d) Suppose the entrepreneur raises the required amount of funds by issuing convertible debt with face value 756 which can be converted into 70% of the chosen project’s equity. Which project will the entrepreneur choose? Is this an equilibrium? Explain briefly your answer. (10 marks) (Word Limit: 300 words)

e) Can you suggest some other security (or combination of securities) which could solve the risk-shifting problem? (Hint: You do not need to do any calculations). (5 marks) (Word Limit: 200 words)